Saturday, November 18, 2017
10:09:12 PM EDT

Twilight Zone Ahead

by
Jim Brown

We are entering that period of the year where crazy things happen for unknown reasons.

The Q3 earnings cycle is over and there are a number of factors that will impact the markets over the next six weeks. Some are positive and some are negative.

Post earnings depression.
Tax loss selling.
Tax avoidance selling.
Stock buybacks.
End of year window dressing.
Investing of year-end bonuses.
Cash is trash purchases before year end.
Portfolio restructuring for 2018.
Potential failure of the tax reform in the senate.
Last but not least, profit taking.

I am not going to describe these all in a lot of detail because I think most readers understand each one. The post earnings depression cycle runs through the end of November. Earnings gains are sold and traders look for stocks to ride into the January earnings cycle.

The tax loss selling is simply closing positions to offset gains or losses in other positions in order to reduce the tax impact. Tax avoidance selling is simply taking profits in this tax year because they expect their tax bracket in 2018 to be higher for reasons not related to the tax reform effort.

The stock buybacks run from the middle of November until the end of December. Companies with outstanding authorizations that run through the end of 2017 will try to close out those authorizations. Others that just started on an authorization will try to make some significant progress to report with their full year earnings reports in January.

Employees that regularly receive large yearend bonuses typically spend the holidays, both Thanksgiving and Christmas deciding where they want to invest the money.

Fund managers sitting on cash and looking for a dip to buy will eventually run out of time and have to buy something. With the markets up double digits for the year, they do not want to have any cash in the bank for the year-end statements. They will want to be fully invested. Cash is trash on the year-end statements. This could lead to a potentially strong market decline in January.

Portfolio managers that have ridden the market up all year will be reducing some of the stocks that have done the best and looking for new positions for 2018. This restructuring is normally done at a casual pace but time is running out on the November statements.

More than 48% of funds close their books for the year in Oct/Nov. They are required to pay out distributions in December so that individuals will have the information for their personal tax returns in January. That means funds are cleaning up their portfolios over the next couple of weeks to prepare for their "fiscal year end" accounting process. Many have already closed their books but there are always laggards.

Never discount the urge to take profits. With the Dow up 18%, Nasdaq 26%, S&P 15%, semiconductors up 44%, biotechs 35%, housing 38%, etc, there are plenty of uncaptured profits in the market. While I believe those profits will be held until January because of the chance of a cheaper tax rate, there is no guarantee. There could be a race to the exits at any time but I just don't see it given all the current fundamentals.

The one event that could push the markets off the cliff would be a failure of the tax reform in the senate. That could cause immediate profit taking because much of the anticipated gains have already been factored into the market.

The major indexes have been trading sideways since October 23rd. for four weeks there has not been any major progress even though the Nasdaq closed at a new high on Thursday. That just matched the high from two weeks ago on Nov 6th.

The big decline last week that saw the indexes close at multi-week lows on Wednesday, setup the potential for a major short squeeze. On Wednesday night I wrote that we were poised for a big squeeze and it happened on Thursday. It was just a squeeze. A million investors die not suddenly wake up on Thursday and decide they wanted to buy Wal-Mart shares $10 higher than they were the day before. These things happen when the market has declined for the prior six days. The shorts all load up and then they get killed when the squeeze appears.

This is similar to playing craps. When a shooter is hot, the other players can accumulate bets all across the board and ever roll that wins they press their bets like they expect the shooter to continue winning for hours to come. When that 7 finally appears, the table is cleared and everybody loses all at once. At least at craps your losses are limited to the amount you have on the table. If you are short stocks when the market turns your losses are unlimited. Foot Locker gained 28% on Friday and their fundamentals still stink. Nobody rushed into the market on Friday because they just had to have some Foot Locker in their account. It was just a short squeeze.

The big decline on Wednesday and the sharp reversal on Thursday messed up the internals and the oscillating indicators. It looks like everyone suddenly turned bullish but that is not what happened. Now it will take 7-10 days for them to level out again.

The A/D line on the S&P reversed sharply from the 3-week low but it did not make a new high. There is a limit to the madness. The MACD on the A/D only showed a minor fluctuation and remains bearish despite the prior bullishness on the actual A/D line.

The S&P Bullish Percent Index ticked up on Thursday because there were so many stocks that spiked $2-$3 in the short squeeze. That was enough to turn the Point & Figure charts bullish on a price basis. The move on the chart was not big and it was just one day but that can linger for weeks on the P&F charts unless there is a corresponding price decline.

The S&P closing high of 2,594 was made on Nov-4th but the index has been trading sideways over support at 2,565 since October 20th. There have been a couple downside breaks but they were immediately bought. The MACD remains bearish. Another close below 2,565 could trigger significant selling as investors are getting nervous because of the lack of forward motion.

The A/D line on the Dow is on the verge of a 4-week low. All the Dow components have reported earnings and there is nothing left to provide lift. Investors are taking profits and moving on to new positions. I expect the A/D to worsen for the rest of November unless the Thanksgiving buying from individual investors provides some support.

The sideways market motion is easily seen on the Dow chart. The index has been in that consolidation pattern since October 24th. Wednesday's close was a 4-week low that looked like a signal for a larger decline. Thursday's short squeeze rescued the Dow but it gave back more than half its gains on Friday. The Dow is the most at risk index because of the narrow 30 stock compensation and all the stocks have reported earnings. The Dow has the biggest air pocket under the current pattern.

The Nasdaq appears to have made a miraculous recovery based on the A/D chart. However, the majority of the big caps tech stocks were negative on Friday. The Nasdaq Composite did close at a new high on Thursday at 6,793 and only gave back 10 points on Friday. That is somewhat bullish if the index can retain those gains. This week will be the key. If the Nasdaq can remain positive it could provide positive sentiment for the entire market. The big cap tech stocks are normally favorites for Thanksgiving week investors.

The FANG stocks moved back into correlation over the last two weeks and that helped keep the Nasdaq within reach of its prior highs.

The Nasdaq has resistance at 6,800 and support at 6,675.

The semiconductor sector weakened last week after a strong run and recent new highs. This was a drag on the Nasdaq but the index did overcome the weight. The $SOX is consolidating rather than declining so that is good news.

The small cap indexes fell the hardest over the last month but rebounded sharply on both Thursday and Friday. The Russell 2000 and the S&P 600 both posted extended gains on Friday while the big cap indexes were lower. I researched why those indexes were positive thinking maybe a single sector could have provided them with lift. I could not find anything. However, the senate voted the tax bill out of committee and that was a positive event since small companies are going to benefit from immediate expensing and lower tax rates.

If the small caps can maintain their upward momentum this week, it would be a plus for the broader market.

I would remain cautious over the next several weeks because of the numerous crosscurrents. The senate vote on the tax bill after Thanksgiving is the biggest near term hurdle. The rest of the points outlined above are not as easily seen in the market. Wells Fargo said a failure of the tax bill would result in an immediate drop of 120-150 S&P points. That would be very painful and it could happen quickly even before the vote if it appears they do not have the votes. There are four senators on the fence and it only takes 3 to kill it. If 2 vote no, VP Pence can be the tiebreaker.

The trend is our friend until it ends but there is rarely any warning.